BANK2011 Notes PDF

lOMoARcPSD|26117221 BANK2011 Notes Banking and the Financial System (University of Sydney) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Do...

lOMoARcPSD|26117221 BANK2011 Notes Banking and the Financial System (University of Sydney) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by Long ([email protected])  lOMoARcPSD|26117221 BANK2011 Notes Lecture 1 – Introduction Six parts of the Financial System: 1. Money – to pay for purchases and store wealth 2. Financial instruments – to transfer resources from savers to investors and to transfer risk to those best equipped to bear it 3. Financial markets – to buy and sell financial instruments 4. Financial institutions – to provide access to financial markets, collect information and provide services 5. Regulatory agencies – to provide oversight for financial system 6. Central banks – to monitor financial institutions and stabilise the economy Money:  Money has changed from gold/silver coins to paper currency to electronic funds  Cash can be obtained from an ATM anywhere in the world  Bills are paid and transactions are checked online Financial instruments:  Transfers resources from savers to investors  Buying and selling individual stocks used to be only for the wealthy  Today we have mutual funds and other stocks available through banks or online  Putting together a portfolio is open to everyone Financial markets:  Allow the buying and selling of financial instruments easily  Went from being in coffee houses and taverns to well organised markets like the New York Stock Exchange  Now transactions are mostly handled by electronic markets – has reduced the cost of processing financial transactions making the way for a much broader array of financial instruments available Financial institutions:  Provide all services of the financial system like providing access to financial markets and gathering information  Banks began as vaults, developed into institutions that accepted deposits and gave loans, and evolved to today’s financial supermarket Government regulatory agencies:  Make sure the elements of the financial system operate safely and reliably  Government regulatory agencies were introduced by federal government after the Great Depression Downloaded by Long ([email protected])  lOMoARcPSD|26117221  They provide wide-ranging financial regulation, rules, and supervision, and examine the systems a bank uses to manage its risk  2007-09 financial crisis has led governments to strengthen regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act Central banks:  They monitor and stabilise the financial system  Central banks began as large private banks to finance wars  Central banks control the availability of money and credit to promote low inflation, high growth and stability of financial system  Today’s policymakers strive for transparency in their operations  The financial crisis of 2007-09 has led the U.S. central bank to try many new policy tools Five core principles of money and banking:  Time has value  Risk requires compensation  Information is the basis for decisions  Markets determine prices and allocate resources  Stability improves welfare Time has value:  Time affects the value of financial instruments  Interest is paid to compensate the lenders for the time the borrowers have their money Risk requires compensation:  Individuals will accept risk only if they are compensated  In the financial world, compensation comes in the form of explicit payments – the higher the risk the bigger the payment Information is the basis for decisions:  The more important the decision, the more information we gather  Collection and processing of information is the foundation of the financial system Markets determine prices and allocate resources:  Markets are the core of the economic system  Markets channel resources and minimise the cost of gathering information and making transactions  In general, the better developed the financial markets, the faster the country will grow Stability improves welfare:  A stable economy reduces risk and improves everyone’s welfare  Financial instability between mid-207 and early-2009 triggered the worse global downturn since the Great Depression  A stable economy grows faster than an unstable one Downloaded by Long ([email protected])  lOMoARcPSD|26117221  One of the main roles of central banks is stabilising the economy Sources of economic and financial news and date:  Daily: o The Wall Street Journal o Financial Times o Bloomberg o Yahoo! Finance  Weekly: o The Economist o Bloomberg Business Week  Data: o The Federal Reserve Board of St. Louis (FRED) o Bureau of Labor Statistics o Bureau of Economic Analysis o The Federal Reserve Board website Lecture 2 – Money and the payments system Money and how we use it:  Money is an asset generally accepted as payment for goods and services or repayment of debt  Income is a flow of earnings over time  Wealth is the value of assets minus liabilities  Money has three characteristics: o Mean of payment o Unit of account o Store of value  Means of payment: o People insist on payment in money o Money is easier and finalises payments so there is no further claim on buyers and sellers o Increase in number of transactions and number of buyers and sellers requires something like ‘money’ to make transactions smoother  Unit of account: o Money is used to quote prices and record debts – it’s a standard of value o Prices provide information needed to ensure resources are allocated to their best uses o Using dollars makes relative price comparisons easier  Store of value: o A means of payment has to be durable and capable of transferring purchasing power from one day to the next o Paper currency does degrade but is accepted at face value in transactions o Other forms of wealth are also a store of value – stocks, bonds, houses, etc Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Although other stores of values are sometimes better than money, we hold money because it’s liquid o Liquidity – a measure of the ease with which an asset can be turned into a means of payment  The more costly it is to convert an asset into money, the less liquid it is o Financial institutions use:  Market liquidity – ability to sell assets for money  Funding liquidity – ability to borrow money to buy securities or make loans The payments system:  Payments system – web of arrangements allowing for exchange of goods and services, as well as assets o The efficient operation of the economy depends on the payments system  The possible methods of payment are: o Commodity and Fiat monies o Cheques o Electronic payments Commodity and Fiat monies:  Commodity monies – things with intrinsic value o For example – silk, gold, iron ore  To be successful, commodity money must be: o Usable by most people o Can be made into standardised quantities o Durable o Easily transportable o Divisible into smaller units  Today’s paper money is called fiat money – its value comes from government decree, or fiat  Willing to accept these bills as payment because federal government stands behind its paper money – money is about trust  Today, some critics of fiat money advocate a return to the gold standard: o There is fear of governments issuing too much paper money o Even if government promises today to limit fiat money, it can renege on the commitment in the future, casting doubt today on the money’s value  Gold standard may not be time consistent: o In a crisis, government can renege on its commitment to use gold as a unit of account o Many countries exited gold standard during Great Depression to restore economic stability  Fiat currency must be limited in volume of circulation to be credible Cheques: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Cheque – an instruction to the bank to take funds from your account and transfer them to another account o Therefore not a final payment – at least, not in the same sense as currency o Sets in motion a series of transactions eventually leading to final payment  Series of transactions put in motion can be seen below: Electronic payments:  Electronic payments take the form of: o Credit and debit cards o Electronic funds transfers  Debit cards: o Work like a cheque in that it tells bank to transfer funds from cardholder’s account to merchant’s account  Credit cards: o Promise by a bank to lend cardholder money to make a purchase o Don’t represent money  Electronic funds transfers (EFTs): o Movements of funds directly from one account to another o Most common form is automated clearinghouse (ACH) transaction:  Used for recurring payments such as pay cheques or utility bills  Have surpassed value of cheques o Banks use electronic transfers for bank-to-bank transactions, sending money through Fedwire Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Rapid innovation is reducing cost and increasing speed of payments and transfers o Has been a proliferation of smartphone apps and infrastructure by Amazon Pay, Apple Pay, PayPal, Google Pay, etc o In some cases, digital wallets are linked to a person’s bank account or credit card – in others, service provider requires transfer of funds prior to any purchase o Goal of these digital systems is to improve reliability, ensure security, and prevent use for criminal purposes The future of money:  Future of the three functions of money: o Means of payment – disappearing due to ease of electronic transactions o Unit of account – likely to remain  Will always be needed to quote values and prices because it’s efficient o Store of value – disappearing due to liquidity of many financial instruments Measuring money:  Changes in quantity of money are related to: o Interest rates o Economic growth o Inflation  Inflation – process of prices rising  Inflation rate – measurement of the inflation process o With inflation, you need more money to buy the same basket of goods o Primary cause of inflation is too much money  Value of the means of payment depends on how much of it is circulating o Must therefore be able to measure how much is circulating  Defining money means defining liquidity Liquidity spectrum: Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Measuring money:  Different definitions of money are based upon degree of liquidity  Drawing the line in different places has led to several measures of money called the monetary aggregates – M1 and M2 o M1 – narrowest definition  the most liquid assets o M2 – broader definition  includes assets not used as means of payment The monetary aggregates: Measuring money:  Which M do we use to understand inflation? o Until early 1980s, used M1 o With changes in accounts, M2 became more useful Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Savings deposits, money-market deposit accounts, and retail money-market mutual fund shares in M2 represent nearly one- half of GDP  M1 no longer a useful measure of money  How useful is M2 in tracking inflation? o When quantity of money grows quickly, it produces high inflation o While there was positive correlation between M2 and inflation until 1980, from 1990-2019 there is virtually no correlation o M2 has stopped being a useful tool for forecasting inflation  Why does M2 no longer predict inflation? o Maybe relationship only applies at high levels of inflation o Maybe it only shows up over longer periods of time o Maybe we need a new measure of money that takes into account recent changes in the way we make payments and use money  We do know that at low levels of money growth, inflation is likely to stay low Lecture 2 reading – Stablecoins: Market Developments, Risks and Regulation Introduction:  Stablecoins – type of crypto-asset designed to maintain stable value relative to a specified unit of account or store of value, such as a national currency or commodity  They aim to overcome some of the shortcomings of unbacked crypto-assets (e.g. Bitcoin) particularly price volatility, making them more attractive as a means of payment or store of value  They play an important role in systems underpinning trading and use of crypto-assets o Commonly used as a ‘bridge’ to facilitate trade between traditional assets and other crypto-assets or between different crypto-assets – improves functioning of crypto-asset markets o Act as a safer store of value in the crypto ecosystem  In December 2022, value of stablecoins on issue fell from US$185 billion (April 2022) to US$150 billion following collapse of large algorithmic stablecoin and associated widespread volatility in crypto-asset markets (occurring in May 2022)  Stablecoin issuers are increasingly considering use cases extending beyond crypto ecosystem – significant interest globally in potential for well-regulated stablecoins to enhance efficiency and functionality of payment and financial services  More widespread use of stablecoins for payments would generate similar risks as other payment systems, although the underlying technology could change the nature or severity of some risks  International regulatory community is focusing on ‘payment stablecoins’, a subset of stablecoins with features designed to facilitate widespread use as means of payment Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Council of Financial Regulators (CFR) in Australia is working on options to incorporate payment stablecoins into regulatory framework for stored-value facilities The rapid rise of the stablecoin market:  Market grown considerably over past few years, with activity concentrated in a few US dollar denominated markets – these stablecoins are primarily used to facilitate speculative trading in crypto-assets  Using stablecoins to transact in crypto-assets reduces need for market participants to convert funds into and out of national currencies  lower fees and increasing efficiency of trades  Two largest stablecoins are Tether and USD Coin – with market capitalisations of US$65 billion and US$45 billion respectively  Both coins are asset-backed stablecoins – issuer holds (or claims to hold) assets fully backing the value of the coins on issue  There are also algorithmic stablecoins, not backed by high-quality liquid assets but instead attempt to maintain a stable value by adjusting supply of stablecoin on issue in response to changes in demand through various types of algorithms and incentive mechanisms Applications beyond the crypto ecosystem:  Stablecoin issuers increasingly considering using stablecoins for functions beyond the crypto ecosystem with a view to enhance the efficiency and functionality of payments and other financial services o These functions tend to focus on stablecoins as a means of payment and as a settlement asset in transactions involving ‘tokenised’ and other types of digital assets Current and emerging risks:  Risks depend on a range of factors, such as the design of the stablecoin arrangement and its applications  Stablecoins fully backed by high-quality liquid assets carry substantially less risk than other stablecoins  Due to relatively small size of the market and limited use of stablecoins outside the crypto ecosystem, they don’t yet pose risks to financial stability, but could in the future  Market and liquidity risks: o Stablecoins can be vulnerable to runs, where a sudden spike in redemption requests results in the ‘fire sale’ of the assets backing the stablecoin o Design of a stablecoin arrangement can limit its vulnerability to runs and other risks o Transparent government arrangements can provide investors with confidence in the issuer’s assertions regarding the value and liquidity of its reserve assets Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Stablecoin issuers can also provide investors with legal certainty around their redemption rights, including in the event of an issuer insolvency o Algorithmic stablecoins, not backed by financial assets, are inherently fragile as stability depends on investors’ confidence in the value of a related unbacked crypto-asset  Operational risks: o Stablecoins and other crypto-assets are susceptible to operational risks, including fraud and cyber risks o These risks arise from a number of sources:  Opacity and complexity of the crypto ecosystem  Widespread use of third-party service providers such as exchanges and custody services  Lack of resource for lost or stolen crypto-assets o These issues are compounded by incomplete regulation across the crypto ecosystem o Regulators are highly attentive to these risks and are in the process of developing regulatory frameworks for stablecoins, other crypto-assets, and crypto-asset service providers  Financial stability risks: o Currently pose minimal risks to financial stability because of the small size of the market relative to other asset classes and the limited use of stablecoins outside the crypto ecosystem o Continued growth and new use cases could introduce risks to financial stability  Increased bank exposure: o Banks could face a number of risks from stablecoins:  A run on a stablecoin could result in sharp deposit outflows from some banks or disruptions to other sources of bank funding  Banks with direct exposure to stablecoins could face losses on those exposures in the event they decline in value  Banks could face legal, operational and reputational risks  Banks issuing their own stablecoins may face implications for their liquidity management and operational resilience, as well as for customer and payment systems  Disruptions to funding markets: o A run on a stable coin could trigger fire sales of reserve assets o This could cause or exacerbate dysfunction in important funding markets, particularly if it occurred during a period of broader market stress  Risks to the payments system: o More widespread use of stablecoins for payments would generate similar risks as other payment systems Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o The extent of any resulting financial stability risks would depend on scale and nature of the system and its use in critical financial services  Energy and climate-related impacts: o Some existing stablecoin technologies rely on proof-of-work consensus mechanisms to validate transactions, which are highly energy-intensive and therefore have potential to contribute to climate change o Proof-of-work is slower and less scalable than some less energy-intensive mechanisms such as proof-of-stake o More widespread adoption of stablecoins for applications such as payments may depend on issuers migrating to less energy- intensive technologies Emerging regulation of stablecoins:  One focus is on identifying the extent to which stablecoin arrangements share common features with traditional financial system, with the goal of producing technology neutral regulation  Common theme emerging across jurisdictions is to consider regulatory requirements for payment-related stablecoins as a priority  International regulation – developing a consistent approach: o Significant work is being undertaken to understand financial stability risks stemming from crypto ecosystem and the need for regulatory adjustments o International bodies are leading work to develop consistent and comprehensive regulatory approach for global stablecoins  Australian regulation – CFR focusing on payment stablecoins: o Work is being led by the Treasury, with support from CFR agencies and other regulations o CFR has agreed that developing a framework for regulating payment stablecoins is priority in the near term, given potential for these arrangements to become widely used as a means of payment and a store of value Conclusion:  Stablecoins have potential to enhance efficiency and functionality of a range of payment and other financial services, but carry risks for investors, users and potentially the broader financial system  Risks depend on a range of factors, including design of the stablecoin and its links with traditional financial system  Interest in Australian dollar stablecoins is growing and the market could develop rapidly as use cases emerge, particularly as a means of payment or settlement asset  Regulators are undertaking significant work to understand how stablecoins can support innovation while providing appropriate safeguards for investors and users, consistent with overall stability of the financial system Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Lecture 3 – Elements of the financial system Introduction:  Direct finance – borrowers sell securities directly to lenders in financial markets o Provides financing for governments and corporations  Indirect finance – institution stands between lender and borrower o For example – getting a loan from a bank/finance company to buy a car  Asset – something of value you own  Liability – something you own  Financial development is linked to economic growth  Role of financial system is to facilitate production, employment and consumption  Resources are funnelled through the system so resources flow to most efficient uses Fuds flowing through the financial system: Lessons from the crisis – leverage:  Leverage – the use of borrowing to finance part of an investment o Played a key role in the GFC  The more leverage, the greater the risk that an adverse surprise will lead to bankruptcy  Financial institutions are much more highly leveraged than households or firms o During crisis, some important financial firms were leveraged more than 30 times their net worth o Such high leverage meant these firms were vulnerable even to a minor decline in the value of their assets  When losses are experienced, firms try to deleverage to raise net worth o As many institutions deleveraged, prices fell, losses increased, and net worth fell  This ‘paradox of leverage’ reinforces the destabilising liquidity spiral Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Both spirals fed the cycle of falling prices and widespread deleveraging that was an indicator of the GFC o Financial system steadied only after massive government interventions in response to plunge of many asset prices Financial instruments:  Financial instrument – written legal obligation of one party to transfer something of value (usually money) to another party at some future date under specified conditions o Enforceability of the obligation is important o Financial instrument obligates one party to transfer something to another o Financial instrument specifies payment will be made at some future date o Financial instrument specifies conditions under which a payment will be made Uses of financial instruments:  Three functions: o Financial instruments act as a means of payment (unlike money)  For example – employees taking stock options as payment for working o Financial instruments act as stores of value (like money)  Financial instruments can be used to transfer purchasing power into the future o Financial instruments allow for the transfer of risk (unlike money)  For example – futures and insurance contracts allow one person to transfer risk to another Characteristics of financial instruments:  Contracts can be very complex o The complexity is costly, and people don’t want to bear these costs  Standardisation of financial instruments overcomes potential costs of complexity  Financial instruments also communicate information, summarising certain details about the issuer  Financial instruments are designed to handle the problem of asymmetric information – borrowers have some information they don’t disclose to lenders Underlying vs derivative instruments:  Underlying instruments – used by savers/lenders to transfer resources directly to investors/borrowers: o Improves efficient allocation of resources o Examples – stocks and bonds Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Derivative instruments – those where their value and payoffs are derived from behaviour of the underlying instruments o Primary use is to shift risk among investors o Examples – futures, options and swaps Primer for valuing financial instruments:  Four fundamental characteristics influencing value of a financial instrument: o Size of the payment – larger payments are more valuable o Timing of payment – payments made sooner are more valuable o Likelihood payment will be made – payments more likely to be made are more valuable o Circumstances under which payment is to be made – payments made when we need them are more valuable Financial instruments used primarily as stores of value:  Bank loans: o Borrower obtains resources from a lender to be repaid in the future  Bonds: o Form of loan issues by corporation or government o Can be bought and sold in financial markets  Home mortgages: o Home buyers usually need to borrow using home as collateral for the loan o Collateral – specific asset borrower pledges to protect lender’s interests  Stocks: o Holder owns a small piece of the firm and is entitled to part of its profits o Firms sell stocks to raise money o Buyers of stocks use them primarily as stores of wealth  Asset-backed securities: o Asset-backed securities – shares in returns/payments arising from specific assets, such as home mortgages or credit card debt o Mortgage-backed securities – bundle large number of mortgages together into pool in which shares are sold  Securities backed by sub-prime mortgages played prominent role in GFC Financial instruments used primarily to transfer risk:  Insurance contracts: o Primary purpose to ensure payments will be made under particular and often rare circumstances  Futures contracts: Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Agreement between two parties to exchange a fixed quantity of a commodity/asset at a fixed price on a set future date o Price is always specified o This is a type of derivative instrument  Options: o Derivative instruments whose prices are based on the value of an underlying asset o Gives holder the right, but not obligation, to buy/sell fixed quantity of the asset at a pre-determined price on either a specific date or at any time during a specified period  Swaps: o Agreements to exchange two specific cash flows at certain times in the future o Come in many varieties, reflecting differences in maturity, payment frequency, and underlying cash flows Financial markets:  Financial markets – places where financial instruments are bought and sold  The economy’s central nervous system  Enable both firms and individuals to find financing for their activities  Promote economic efficiency The role of financial markets:  Market liquidity: o Ensures owners of financial instruments can buy/sell them cheaply and easily o Keeps transaction costs low  Information: o Pool and communicate information about issuers of financial instruments  Risk sharing: o Provide individuals with a place to buy/sell risks Structure of financial markets:  Distinguish between primary and secondary markets  Categorised by the way they trade  Group based on type of instrument they trade Primary vs secondary markets:  Primary financial market – borrower obtains funds from a lender by selling newly issued securities  Secondary financial market – where people can buy/sell existing securities Secondary-market trading in stocks:  Historically there were: o Centralised exchanges – buyers and sellers meet in a central, physical location Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Over-the-counter (OTC) markets – decentralised markets where dealers stand ready to buy and sell securities electronically  More recently, there are electronic communication networks (ECNs): o Electronic system bringing buyers and sellers together without use of broker or dealer  Pace of structural change has accelerated dramatically: o Ongoing technological advances in computing and communications – lowered importance of physical location of exchange o Increased globalisation – encouraged more cross-border mergers of exchanges  Decentralised electronic exchanges have benefits: o Customers can see their orders o Orders happen quickly o Can trade 24 hours a day o Low cost o Reduces operational risk  Decentralised electronic exchanges also have risks: o Electronic operations prone to errors threatening the existence of brokers o New trading patterns have arisen rendering the system fragile:  Trading algorithm – rule-based program for automatically executing hundreds/thousands of trades  High frequency traders (HFTs) – can purchase/sell thousands of stocks in seconds o Can also see efforts to speed up electronic trading draining resources from other uses o Could diminish willingness of market makers to provide liquidity Debtand equity vs derivative markets:  Debt markets – markets for loans, mortgages and bonds  Equity markets – markets for stocks  Derivative markets – markets where investors trade instruments like futures, options and swaps  In debt and equity markets, actual claims are bought/sold for immediate cash payments  In derivative markets, investors make agreements that are settled later  Debt instruments categorised by loan’s maturity: o Debt instruments completely repaid in less than a year (from original maturity date) are traded in money markets o Those with maturity of more than a year are traded in bond markets Characteristics of a well-run financial market:  Must be designed to keep transaction costs low Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Information the market pools and communicates must be accurate and widely available  Borrowers’ promises to pay lenders must be credible o Lenders must be able to enforce their right to receive repayment quickly and at low cost Financial institutions:  Financial institutions – firms providing access to financial markets to: o Savers who wish to purchase financial instruments directly o Borrowers who want to issue them  Also known as financial intermediaries  Examples – banks, insurance companies, securities firms, pension funds Role of financial institutions:  Reduce transaction costs by specialising in issuance of standardised securities  Reduce information costs of screening and monitoring borrowers o Curb information asymmetries, helping resources flow to most productive uses  Give savers ready access to their funds Flow of funds through financial institutions: Structure of the financial industry:  Can divide intermediaries into two broad categories: o Depository institutions: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Take deposits and make loans  What most people think of as banks o Non-depository institutions:  Include insurance companies, securities firms, asset management firms, hedge funds, private equity/venture capital firms, finance companies and pension funds 1. Depository institutions – take deposits and make loans 2. Insurance companies – accept premiums, which they invest in securities and real estate, in return for promising compensation to policyholders should certain events occur 3. Pension funds – invest individual and company contributions in stocks, bond, and real estate in order to provide payments to retired workers 4. Securities firms – include brokers, investment banks, underwriters, asset management firms, private equity firms and venture capital firms o Brokers and investment banks issue stocks and bonds for corporate customers, trade them, and advise clients o Asset management firms pool resources of individuals and companies and invest them in portfolios of bonds, stocks and real estate o Hedge funds do the same for small groups of wealthy investors o Private equity and venture capital firms serve wealthy investors by acquiring controlling stakes in a few firms and managing them actively 5. Finance companies – raise funds directly in financial markets in order to make loans to individuals and firms 6. Government-sponsored enterprises (GSEs) – federal credit agencies that provide loans directly for farmers and home mortgagors Lecture 4 – Interest rates and risk aversion Introduction:  Credit is one of the critical mechanisms we have for allocating resources  Interest rates link the present to the future: o Allow us to compare payments made on different dates o Tell us future reward for lending today o Tell us the cost of borrowing now and repaying later Valuing monetary payments now and in the future:  To compare the value of payments made on different dates, we need: o Future value o Present value Future value and compound interest: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Future value – value on some future date of an investment made today  The higher the interest rate or the higher the amount invested, the higher the future value  Compound interest – the interest on interest  Basis point – 1 one-hundredth of a percentage point  0.01% Present value:  Present value – value today of a payment that is promised to be made in the future  Present value is higher when: o Future value of the payment is higher o Time until the payment is shorter o Interest rate is lower How present value changes:  Doubling the future value of the payment, without changing the time of payment or the interest rate, doubles the present values  The sooner a payment is to be made, the more it’s worth  Higher interest rates are associated with lower present values, no matter what the size or timing of the payment  At any fixed interest rate, an increase in the time until a payment is made reduces its present value Internal rate of return:  Internal rate of return – interest rate that equates the present value of an investment with its cost  To find internal rate of return, take sum of the present value of each of the yearly revenues and equate it with the investment’s cost  Should invest if the internal rate of return exceeds the interest rate needed to finance the investment Bond basics:  Bond – promise to make a series of payments on specific future dates  Bonds create obligations, and are therefore thought of as legal contracts that: o Require borrower to make payments to the lender o Specify what happens if the borrower fails to do so Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Coupon bond is the most common type of bond o Issuer makes annual payments called coupon payments o Annual amount of those payments is the coupon rate o The bond specifies when it will repay the initial investment, the date is called the maturity date/term to maturity o The final payment, a repayment of the initial loan, is referred to as the principal/face value/par value  Present value of the bond principal: o The higher the n, the lower the value of the payment Valuing the coupon payments:  The longer the payments go, the higher their total value  The higher the interest rate, the lower the present value  Present value of coupon payments: Valuing the coupon payments plus principal:  Can combine previous two equations to get:  Value of the coupon bond rises when: o Yearly coupon payments rise o Interest rate falls Bond pricing:  Relationship between bond prices and interest rates is important o The higher the interest rate, the lower their present value  Value of a bond varies inversely with interest rate used to calculate the present value of the promised payment Real and nominal interest rates:  Nominal interest rate is used to calculate present value  Need to adjust the return on a loan using the real interest rate, the inflation-adjusted interest rate  Nominal interest rate (i) must be based on expected inflation (e) over the term of the loan, plus the real interest rate (r) Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o This is the fisher equation o The higher expected inflation, the higher the nominal interest rate  Financial markets quote nominal interest rates  When people use the term interest rate without qualification, they’re referring to nominal interest rate  Cannot directly observe the real interest rate, have to estimate it: Defining risk:  Risk – measure of uncertainty about future payoff to an investment, assessed over some time horizon and relative to a benchmark  Risk is a measure that can be quantified  Risk arises from uncertainty about the future  Risk has to do with future payoff of an investment  Definition of risk refers to an investment or group of investments  Risk must be assessed over some time horizon  Risk must be measured relative to a benchmark, not in isolation o Benchmark – standard against which something is compared Possibilities, probabilities and expected value:  Probability – measure of the likelihood that an event will occur  In considering probability, need to: o List all possible outcomes o Figure out chance of each one occurring  Expected value of the investment – average or most likely outcome Measures of risk:  Risk-free asset – investment whose future value is known with certainty and whose return is the risk-free rate of return o Payoff received is guaranteed and cannot vary  Can measure risk by quantifying spread among an investment’s possible outcomes Variance and standard deviation:  Variance – average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities  Standard deviation – positive square root of the variance  Standard deviation is more useful than variance because it’s measured in same units as the payoffs (dollars) Value at risk:  Sometimes more concerned with the value of the worst possible outcome than the spread of possible outcomes  Value at risk (VaR) – worst possible loss over a specific time horizon, at a given probability Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o By restricting sorts of financial instruments banks can hold, bank managers and financial regulators try to limit chances of financial collapse Risk aversion, risk premium, and risk-return trade-off:  Risk averse investors prefer an investment with certain return to one with the same expected return but any amount of uncertainty  A risky investment must have an expected return higher than the return on a risk-free asset – it must offer a risk premium  The riskier the investment, the higher the risk premium Sources of risk:  Classify risks into one of two groups: o Idiosyncratic risks (unique risks) – affect a small number of people but no one else o Systematic risks (economywide risks) – affect everyone  Idiosyncratic risks come in two types: o One set of firms is affected in one way and other firms in another way  For example – a change in the price of oil o Some unique risks are specific to one person or company and no one else Reducing risk through diversification:  Risk can be reduced through diversification – holding more than one risk at a time o Holding several different investments can reduce idiosyncratic risk an investor bears  Can hedge risks or can spread them among many investments Hedging risks:  Hedging – strategy of reducing idiosyncratic risk by making two investments with opposing risks o When one does poorly, the other does well Spreading risk:  Can’t always reduce risk through hedging as investments don’t always move predictably in opposite directions  Alternative is to spread risk around – find investments whose payoffs are unrelated  The more independent sources of risk you hold in your portfolio, the lower the overall risk  As we add more and more independent sources of risk, standard deviation becomes negligible  Diversification through spreading of risk is the basis for the insurance business Lecture 5 – Bond prices and yields Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Bond prices:  Standard bond specifies fixed amounts to be paid and exact dates of the payments  How much is paid for the bond depends on its characteristics  Four basic types of bonds: o Zero-coupon bonds – promise a single payment, such as a U.S. Treasury Bill o Fixed-payment loans – such as conventional mortgages o Coupon bonds – make periodic interest payments and repay principal at maturity o Consols – make periodic interest payments forever, never repaying principal that was borrowed Zero-coupon bonds:  U.S. Treasury bills (T-bills) are the most straightforward type of bond o Each T-bill represents a promise by the government to pay $100 on a fixed future date o There are no coupon payments, which is why they’re known as zero-coupon bonds o Also called pure discount bonds (or just discount bonds), because price is less than face value – they sell at a discount o Interest rate and price of the bond have inverse relationship Fixed-payment loans:  Promise a fixed number of equal payments at regular intervals  Loans are amortised, meaning the borrower pays off the principal along with interest over the life of the loan  Value of the loan today is the present value of all payments: Coupon bonds:  Issuer of a coupon bond promises to make series of periodic interest payments (coupon payments), plus a principal payment at maturity  Price of the coupon bond: Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Consols:  Consols/perpetuities are like coupon bonds whose payments last forever  Price of a consol is the present value of all future interest payments: Yield to maturity:  Most useful measure of the return on holding a bond – the yield bondholders receive if they hold the bond to its maturity when final principal payment is made o i is the yield to maturity  remembering present value and interest rates move in opposite directions, the following can be concluded: o If bond price = $100, YTM = coupon rate o If bond price > $100, YTM < coupon rate o If bond price < $100, YTM > coupon rate Holding period returns:  Holding period return – return to buying a bond and selling it before it matures  Holding period return can differ from yield to maturity  One-year holding period return is the sum of yearly coupon payment divided by price paid for the bond, and the change in the price divided by price paid:  Whenever price of a bond changes, there is capital gain or loss o The greater the price change, the more important a part of the holding period return the capital gain or loss becomes o The longer the term of the bond, the greater those price movements and associated risk can be Downloaded by Long ([email protected])  lOMoARcPSD|26117221 The bond market and determination of interest rates:  Best way to see how bond prices are determined and why they change is to look at bond supply, demand and equilibrium prices in bond market Bond supply, bond demand, and equilibrium in the bond market:  Bond prices and yields are determined by supply and demand  Bond supply curve is the relationship between price and quantity of bonds people are willing to sell, all else equal o The higher the price of the bond, the larger quantity supplied o Bond supply curve slopes upwards  Bond demand curve is the relationship between price and quantity of bonds investors demand, all else equal o The lower the potential price bondholders must pay for a fixed-dollar payment on a future date, the more likely they are to buy the bond o Bond demand curve slopes downwards  Equilibrium is where supply meets demand (point E)  If bond prices start above equilibrium, quantity supply will exceed quantity demanded o Excess supply means suppliers can’t sell bonds they want to at current price o To make the sale, they’ll cut the price o Excess demand will put downward pressure on prices until supply equals demand  When price is below equilibrium, quantity demanded will exceed quantity supplied o Those who want to buy bonds can’t get all they want at the price o They’ll bid up the price o Excess demand will put upward pressure on prices until demand equals supply Why bonds are risky:  How can bonds be risky? Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o They are promises to make fixed payments at future dates  Bondholders face three major risks: o Default risk – issuer may not make promised payments on time o Inflation risk – inflation may turn out to be higher than expected, reducing real return on holding the bond o Interest rate risk – interest rates may rise between time bond is purchased and time it’s sold, reducing bond’s price Default risk:  No guarantee that a bond issuer will make promised payments o Usually ignore default risk with T-bills, but can’t ignore default risk of bonds issued by many other governments or private corporations  The price of a risk free 5% coupon bond would be:  If there is a 10% probability of default, the expected value of the payment of the bond is $94.50, and therefore:  Implying a yield to maturity of:  As default-risk premium is promised yield to maturity minus risk-free rate, it is 16.67% - 5% = 11.67%  The higher the default risk, the higher the yield Inflation risk:  With few exceptions, bonds promise to make fixed-dollar payments  In order to maintain purchasing power, nominal interest rate should equal the real interest rate plus expected inflation plus compensation for inflation risk  The greater the inflation risk, the greater the compensation for it will be Interest rate risk:  Interest rate risk arises from the fact investors don’t know holding period return of long-term bonds o When interest rates change, bond prices move o The longer the term of the bond, the larger the price change for a given change in the interest rate  For investors with holding periods shorter than maturity of the bond, potential for a change in interest rates creates risk Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o The more likely the interest rates are to change during bondholder’s investment horizon, the larger the risk of holding a bond Ratings and the risk structure of interest rates:  Default is one of the most important risks a bondholder faces o Risk that an issuer will fail to make a bond’s promised payments varies substantially from one borrower to another  Independent companies have come into existence to evaluate creditworthiness of potential borrowers Bond ratings:  Best known bond rating services: o Moody’s o Standard & Poor’s (S&P)  These companies monitor status of individual bond issuers and assess likelihood that a bondholder will be repaid by a bond issuer o Companies with good credit (low levels of debt, high profitability, and sizable amounts of cash assets) earn high bond ratings o High rating suggests that a bond issuer will have little problem meeting a bond’s payment obligations  Top 4 categories (Aaa to Baa in Moody’s ) are considered investment-grade bonds o Very low risk of default o These ratings are reserved for most government issuers as well as corporations among the most financially sound Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Distinction between investment-grade and non-investment-grade bonds is important o A number of regulated institutional investors aren’t allowed to invest in bonds that are rated below investment grade  Speculative grade bonds are those issued by companies/countries that may have difficulty meeting bond payments but aren’t at risk of immediately default  Highly speculative bonds consist of debts that are at serious risk of default  Bonds with ratings below investment grade are often referred to as junk bonds (or high-yield bonds)  Two types of junk bonds: o Fallen angels – were once investment-grade, but issuers fell on hard times o Ones where little is known about the risk of the issuer  Material changes in firm/government’s financial condition cause changes in its debt ratings o Rating downgrade can occur if they experience problems o Rating upgrade can also occur Impact of ratings on yields:  Bond ratings are designed to reflect default risk: o The lower the rating, the higher the risk of default o The lower a bond’s rating, the lower its price and higher its yield  U.S. Treasury bonds have long served as standard for comparison because they are viewed as having little default risk – they’re referred to as benchmark bonds o Yields on other bonds are measured in terms of the spread over Treasuries  Bond yields can be thought of as the sum: o If bond ratings properly reflect the probability of default, the lower the rating of the issuer, the higher the default-risk premium o When Treasury yields move, all other yields move with them  Changes in U.S. Treasury yield account for most of the movement in Aaa and Baa bond yields o Yield on U.S. Treasury bonds is consistently the lowest Term structure of interest rates:  Bonds with same default rate and tax status but different maturity dates usually have different yields – why? o Long-term bonds are riskier than short-term bonds  The relationship among bonds with same risk characteristics but different maturities is called the term structure of interest rates Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Comparing information on 3-month and 10-year Treasury yields, can see that: o Interest rates of different maturities tend to move together o Yields on short-term bonds are more volatile than yields on long-term bonds o Long-term yields tend to be higher than short-term yields The expectations hypothesis:  Expectations hypothesis of the term structure focuses on risk-free interest rate o Risk-free interest rate can be computed, assuming there is no uncertainty about the future  If there’s no uncertainty about the future, an investor will be indifferent between holding a two-year bond and holding a series of two one-year bonds o Certainty means that bonds of different maturities are perfect substitutes for each other  Expectations hypothesis implies that current two-year interest rate should equal the average of the current one-year interest rate and the one-year interest rate one year in the future  According to expectations hypothesis, when interest rates are expected to rise in the future, long-term interest rates will be higher than short-term interest rates o This means the yield curve will slope up  Expectation hypothesis also implies that: o If interest rates are expected to fall, yield curve will slope down o If interest rates are expected to remain unchanged, yield curve will be flat  If bonds of different maturities are perfect substitutes for each other, can construct investment strategies that must have same yields o Invest in a two-year bond and hold it to maturity o Invest in two one-year bonds, one today and a second when the first matures  Expectations hypothesis says that investors will be indifferent between these two strategies Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Indifference between these strategies means they must have the same return and hence:  Can write the two-year interest rate as the average of the current and future expected one-year interest rates:  General statement of the expectations hypothesis is that interest rate on a bond with n years to maturity is the average of n expected future one-year interest rates:  The expectations hypothesis: o Tells us that long-term bond yields are all averages of expected future short-term yields, so interest rates of different maturities will move together o Implies that yields on short-term bonds will be more volatile than yields on long-term bonds – as long-term interest rates are averages of expected short-term rates, if the current 3- month interest rate moves, it will only have a small impact on the 10-year interest rate o Cannot explain why long-term yields are normally higher than short-term yields because it implies that yield curve slopes upward only when interest rates are expected to rise The liquidity premium theory: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Can think of a bond yield as having two parts – one that is risk-free and another that is a risk premium o Expectations hypothesis explains risk-free part o Inflation and interest rate risk explain the risk premium o Together, they form the liquidity premium theory of the term structure of interest rates: Information in the risk structure of interest rates:  Immediate impact of a pending recession is to raise risk premium on privately issued bonds o Economic slowdown/recession doesn’t affect risk of holding government bonds  Increased risk of default isn’t the same for all firms o Impact of recession on companies with high bond ratings is usually quite small o The lower the initial grade of the bond, the more the default- risk premium rises as general economic conditions deteriorate  When the risk spread rises, output (GDP) falls  Information on the term structure (particularly slope of the yield curve) helps forecast general economic conditions o Yield curve usually slopes upward o On rare occasions, short-term interest rates exceed long-term yields – term structure is said to be inverted  Inverted yield curve is a valuable forecasting tool because it predicts a general economic slowdown o When yield curve slopes downwards, it indicates that policy is tight because policymakers are attempting to slow economic growth and inflation  Term spread – difference between yields of different maturities  When term spread falls, GDP growth tends to fall one year later  Yield curve didn’t predict depth or duration of recession of 2007-9 o One-year and two-year market rates didn’t anticipate the persistent plunge of overnight rates o As financial institutions weakened in the crisis, widening risk spread signalled a severe economic downturn – provided a more useful predictor Lecture 6 – Financial intermediation The role of financial intermediaries  Intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Financial markets are important because they price economic resources and allocate them to their most productive uses  The importance of intermediaries: o Banks are still critical providers of financing around the world o Intermediaries determine which firms can access stock and bond markets o Banks decide size of a loan and interest rate to be charged o Securities firms set volume and price of new stock and bond issues when they purchase them for sale to investors o Lending and borrowing involves both transaction costs (cost of writing a loan contract) and information costs (cost of figuring out whether a borrower is trustworthy) – financial institutions exist to reduce these costs  In their role as financial intermediaries, financial institutions perform five functions: o Pooling resources of small savers o Providing safekeeping and accounting services, as well as access to the payments system o Supplying liquidity by converting savers’ balances directly into a means of payment whenever needed o Providing ways to diversify risk o Collecting and processing information in ways that reduce information costs Pooling savings:  Most straightforward economic function of financial intermediaries is to pool the resources of many small savers o By accepting many small deposits, banks empower themselves to make larger loans  To succeed, intermediary must attract substantial number of savers o Means convincing potential depositors of the institution’s soundness Safekeeping, payments system access, and accounting:  Banks are a place where assets are put for safekeeping Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Bank provides depositors with access to payments system – network that transfers funds from the account of one person/business to another o Because banks specialise in handling payments transactions, they can offer these services relatively cheaply o Financial intermediaries reduce costs of financial transactions  Financial intermediaries facilitate exchange of goods and services, promoting specialisation o In efficient companies (those that get the most output from a given set of inputs), people/companies specialise by concentrating on activities with the lowest opportunity cost o Financial intermediaries help economies to function more efficiently  Financial intermediaries provide bookkeeping and accounting services o Help people manage their finances  Providing safekeeping, accounting services, and access to the payments system forces financial intermediaries to write legal contracts o They can hire a lawyer to write one very high-quality contract that can be used repeatedly, reducing the cost of each use o Financial intermediaries take advantage of economies of scale, where average cost falls as quantity increases Providing liquidity:  Liquidity is a measure of the ease and cost with which an asset can be turned into a means of payment  Financial intermediaries offer the ability to transform assets into money at a relatively low cost  Bank can structure its assets accordingly, keeping enough funds in short-term, liquid financial instruments to satisfy the few people who will need them and lend out the rest  By collecting funds from a large number of small investors, bank can reduce cost of their combined investment, offering each individual investor both liquidity and a better rate of return  Intermediaries offer individuals/businesses lines of credit, similar to overdraft protection on chequing accounts o Provides customer access to liquidity  Financial intermediary must specialise in liquidity management o Must design its balance sheet so it can sustain sudden withdrawals Diversifying risk:  Financial institutions enable us to diversify investments and reduce risk  Financial intermediaries provide low-cost way for individuals to diversify their investments Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Mutual fund companies offer small investors a low-cost way to purchase a diversified portfolio of stocks and eliminate idiosyncratic risk associated with any single investment Collecting and processing information:  Information asymmetry as borrower knows whether they’re trustworthy while lender faces substantial costs to obtain the same knowledge/information o Borrowers have information lender doesn’t  By collecting and processing standardised information, financial intermediaries reduce problems information asymmetries create Information asymmetries and information costs:  Information plays central role in structure of financial markets and financial institutions o Markets require sophisticated information to work well – when cost of obtaining that information is too high, markets don’t function o Issuers of financial instruments know more about their business prospects and willingness to work than potential lenders/investors o Asymmetric information is a serious hinderance to operation of financial markets  Asymmetric information poses two important obstacles to smooth flow of funds from savers to investors: o Adverse selection arises before transaction occurs – lenders need to know how to distinguish good credit risks from bad o Moral hazard occurs after the transaction – lenders need to find a way to tell whether borrowers will use proceeds of a loan as they claim they will Adverse selection in financial markets:  If a lender can’t tell whether a borrower is good or bad credit risk, lender will demand a risk premium based on average risk  Borrowers who know they are good credit risks won’t want to borrow at this elevated interest rate  they withdraw from the market, leaving only bad credit risks Solving adverse selection problem:  Must find ways for investors and lenders to distinguish well-run firms from poorly run firms Disclosure of information:  Obvious way to solve the hidden attributes problem is to generate more information o Public companies are required to disclose voluminous amounts of information Downloaded by Long ([email protected])  lOMoARcPSD|26117221  With help of some unethical accountants, company executives found a broad range of ways to manipulate financial statements to disguise their firms’ true financial condition o Although accounting practices have changed, information problems persist  In a limited sense, there is private information collected and sold to investors o Research services like Moody’s, Value Line, and Dun and Bradstreet collect information directly from firms and produce evaluations  To be credible, companies examined cannot pay directly for research themselves, so investors need to o Private information services face a free-rider problem o Free rider – someone who doesn’t pay the cost to get the benefit of the good or service Collateral and net worth:  Collateral – something of value pledged by a borrower to lender in the event of the borrower’s default o Collateral is said to back/secure a loan o When banks make loans without collateral (known as unsecured loans), they typically charge very high interest rates – for example, credit card debt  Net worth – owner’s stake in a firm, the value of the firm’s assets minus liabilities o Net worth serves same purpose as collateral o If firm defaults on a loan, lender can make a claim against the firm’s net worth  From perspective of the mortgage lender, homeowner’s equity serves exactly same function as net worth in a business loan  Importance of net worth in reducing adverse selection is the reason owners of new businesses have so much difficulty borrowing money o Most small business owners must put up their homes and other property as collateral for their business loans o Only after they have managed to establish a successful business and have built up some net worth in it, can they borrow without pledging their personal property Moral hazard – problems and solutions:  Moral hazard arises when we cannot observe people’s actions and therefore cannot judge whether a poor outcome was intentional or just a result of bad luck  Lender’s information problems don’t end with adverse selection o Second information asymmetry arises because borrower knows more than lender about the way borrowed funds will be used and the effort that will go into a project o Moral hazard affects both equity and bond financing Moral hazard in equity finance: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  If you buy a stock, how do you know the company that issued it will use the funds you invested in the way that is best for you? o You have given your funds to managers, who will tend to run the company in the way most advantageous to them o The separation of your ownership from their control creates what is called a principal-agent problem  No one has devised a foolproof way of ensuring managers will behave in the owners’/shareholders’ best interests Moral hazard in debt finance:  When managers are the owners, problem of moral hazard in equity financing disappears  Because debt contracts allow owners to keep all profits in excess of loan payments, they encourage risk taking o Lenders need to find ways to make sure borrowers don’t take too many risks o People with risky projects are attracted to debt finance because they get the full benefit of the upside, while the downside is limited to their collateral Solving the moral hazard problem in debt finance:  Legal contract can solve the moral hazard problem inherent in debt finance o Bonds and loans often carry restrictive covenants that limit amount of risk a borrower can assume o For example – covenant may require the firm to maintain a certain level of net worth, minimum balance in a bank account, or minimum credit rating o Home mortgages often come with restrictive covenants requiring homeowners to purchase fire insurance Summary of negative consequences of information costs: Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Financial intermediaries and information costs:  Much of the information financial intermediaries collect is used to reduce information costs and minimise effects of adverse selection and moral hazard o To reduce potential costs of adverse selection, intermediaries screen loan applicants o To minimise moral hazard, they monitor borrowers o When borrowers fail to live up to their contracts with lenders, financial intermediaries penalise them by enforcing the contracts Screening and certifying to reduce adverse selection:  To get a loan, application must be filled out o Lender uses personal details to identify you to a company that collects and analyses credit information, summarising it for potential lenders in a credit score  The company that collects your credit information and produces your credit score charges a fee each time someone wants to see it o Overcomes the free-rider problem  Banks can collect information on a borrower that goes beyond what their loan application or credit report contains  Underwriters screen and certify firms seeking to raise funds directly in the financial markets o Without certification by one of these firms, companies would find it difficult to raise funds Monitoring to reduce moral hazard: Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Intermediaries insure against moral hazard by monitoring both firms that issue bonds and those that issue stocks  Many financial intermediaries (other than banks) hold significant numbers of shares in individual firms o In some cases, they place a representative on the company’s board of directors to monitor the investment firsthand  For new companies, financial intermediary called a venture capital firm does the monitoring o Specialise in investing in risky new ventures in return for a stake in the ownership and share of profits o They keep a close watch on managers’ actions  Threat of a takeover helps persuade managers to act in interest of the stockholders and bondholders Lecture 7 – Bank management The balance sheet of commercial banks:  Commercial banks – institutions established to provide banking services to businesses, allowing them to deposit funds safely and borrow them when necessary  A bank’s balance sheet specifies that:  Banks obtain funds from individual depositors and businesses, as well as by borrowing them from other financial institutions and through the financial markets o Difference between a bank’s assets and liabilities is the bank’s capital (net worth) – the value of the bank to its owners o Bank’s profits come from both service fees and from difference between what it pays for liabilities and receives on its assets Bank capital and profitability:  Net worth is referred to as bank capital (or equity capital)  Capital is the cushion banks have against sudden drops in the value of their assets or an unexpected withdrawal of liabilities o It provides insurance against insolvency  Important component of bank capital is loan loss reserves – amount the bank sets aside to cover potential losses from defaulted loans o When bank gives up hope a loan will be repaid, it’s written off (erased from bank’s balance sheet) o At that point, loan loss revenue is reduced by amount of loan that has defaulted  Measures of bank profitability: o Return on assets (ROA):  Equals a bank’s net profit after taxes divided by bank’s total assets Downloaded by Long ([email protected])  lOMoARcPSD|26117221  ROA is an important measure of how efficiently a particular bank uses its assets  For the bank’s owners, ROA is less important that the return on their own investment o Return on equity (ROE):  Measures bank’s return to its owners  Equals the bank’s net profit after taxes divided by bank’s capital  ROE tends to be higher for larger banks than small banks, suggesting greater leverage, a riskier mix of assets, or the existence of significant economies of scale o ROA and ROE are related to leverage  One measure of leverage is the ratio of bank assets to bank capital  Multiplying ROA by this ratio yields ROE o Another measure of bank profitability is net interest income  This measure is related to the fact that banks pay interest on their liabilities, creating interest expenses, and receiving interest on their assets, creating interest income  Deposits and bank borrowing create interest expenses, while securities and loans generate interest income  Difference between interest income and expenses is the bank’s net interest income  Net interest income can also be expressed as a percentage of total assets to yield – the net interest margin  This is the bank’s interest rate spread, which is the weighted average difference between interest rate received on assets and interest rate paid for liabilities  Well-run banks have high net interest income and high net interest margin Downloaded by Long ([email protected])  lOMoARcPSD|26117221  If a bank’s net interest margin is currently improving, its profitability is likely to improve in the future Off-balance-sheet activities:  To generate fees, banks engage in off-balance-sheet activities  Banks provided trusted companies with lines of credit, similar to credit limits on credit cards o Firm pays the bank a fee in return for ability to borrow whenever necessary o When agreement is signed, bank receives payment and firm receives a loan commitment o Not until a loan has been made (until firm has drawn down the credit line) does the transaction appear on the bank’s balance sheet  Letters of credit are another important off-balance-sheet activity o These letters guarantee a customer of the bank will be able to make a promised payment o Customer might request the bank sends a commercial letter of credit to an exporter in another country guaranteeing payment for goods on receipt o In return for taking on this risk, bank receives a fee  Standby letter of credit is of similar form to letters of credit o These letters are a form of insurance, issued to firms and governments that wish to borrow in the financial markets o Letters of credit expose the bank to risk in a way not readily apparent on the bank’s balance sheet  Because off-balance-sheet activities create risk for financial institutions, they have come under increasing scrutiny in recent years o By allowing transfer of risk, modern financial instruments enable individual institutions to concentrate risk in ways that are very difficult for outsiders to recognise Bank risk – where it comes from and what to do about it:  Bank’s goal is to make a profit in each of its lines of business o Goal is to pay less for deposits bank receives than for loans it makes and securities is buys  Bank is exposed to the following risks: o Liquidity risk o Credit risk o Interest rate risk o Trading risk Liquidity risk:  Liquidity risk – risk of a sudden demand for liquid funds  Banks face liquidity risk on both sides of their balance sheets o Deposit withdrawal is a liability-side risk, but there is an asset- side risk as well Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Banks provide households and firms with lines of credit – promises to make loans on demand o When this type of loan commitment is claimed, or taken down, bank must find liquidity to cover it  Even if a bank has positive net worth, liquidity can still drive it out of business  In the past, banks would hold sufficient excess reserves to accommodate customers’ withdrawals – a passive way to manage liquidity risk  Holding excess returns is expensive, because it means forgoing higher rate of interest typically earned on loans or securities o Two other ways to manage the risk that customers will require cash – adjusting assets or liabilities  On the asset side, the bank can: o Sell a portion of its securities portfolio  Banks particularly concerned about liquidity risk can structure their securities to facilitate quick and easy sales o Sell some of its loans to another bank  Banks generally make sure a portion of loans they hold are marketable for this purpose o Refuse to renew a customer loan that has come due – this is bad for business  It’s guaranteed to alienate the customer and could drive them to another bank  Reducing assets lowers profitability  Bankers prefer to use liability management to address liquidity risk: o Bank can borrow to meet the shortfall, either from the Federal Reserve or another bank o Bank can attract additional deposits  Most common way is to issue large-denomination certificates of deposit, effectively borrowing in the wholesale money market  Large certificates of deposit have become increasingly important source of funds for banks  This is because they allow banks to manage liquidity risk without changing asset side of their balance sheets  In the financial crisis of 2007-9, many usual mechanisms for managing liquidity risk failed o Banks couldn’t sell their liquid assets or obtain at a reasonable cost the funding needed to hold these assets o Sudden and unanticipated loss of market and funding liquidity threatened the survival or many banks Credit risk:  Credit risk – risk that a bank’s loans won’t be repaid  To manage credit risk, banks can diversify or undergo credit risk analysis Downloaded by Long ([email protected])  lOMoARcPSD|26117221  Diversification – spreading risk, which can be difficult for banks, especially those focusing on certain kinds of lending o If a bank lends in only one geographic area or only one industry, it exposes itself to economic downturns that are local or industry-specific o It’s important banks find a way to hedge these risks  Credit risk analysis – uses a combination of statistical models and information that is specific to the loan applicant o Result is an assessment of the likelihood that a particular borrower will default  In financial crisis of 2007-9, many banks seriously underestimated risks associated with mortgage and other household credit Interest rate risk:  Mismatch between the assets and liabilities on the balance sheet create interest rate risk  When interest rates rise, banks face risk that the value of their assets will fall more than the value of their liabilities, reducing the bank’s capital o Rising interest rates reduce revenues relative to expenses, directly lowering bank’s profits  Interest rate sensitive – a change in interest rates will changes revenue produced by an asset  When bank’s liabilities are more interest rate sensitive than its assets, an increase in interest rates will cut into bank profits  First step in managing interest rate risk is to determine how sensitive the bank’s balance sheet is to a change in interest rates o Managers must compute an estimate of the change in bank profits for each one percentage-point-change in the interest rate – called gap analysis o Gap analysis can be refined to take account of differences in the maturity of assets and liabilities, but the analysis quickly becomes complicated  Bank managers can use a number of tools to manage interest-rate risk o Can match interest rate sensitivity of assets with interest rate sensitivity of liabilities  While this approach reduces interest rate risk, it increase credit risk o Alternatives include the use of derivatives, specifically interest rate swaps Trading risk:  Trading risk (or market risk) – if the price at which an instrument is purchased differs from the price at which it’s sold, the risk is that the instrument may go down in value rather than up  Traders normally share in the profit from good investments, but the bank pays for losses Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o This arrangement creates moral hazard – traders have an incentive to take more risk than bank managers would like  Solution to moral hazard problem in trading is to compute the risk traders generate using measures like standard deviation and value at risk o Bank’s risk manager limits amount of risk any individual trader is allowed to assume and monitors each trader’s holdings closely o Large banks find it difficult to monitor their traders and the managers who are supposed to be doing the monitoring  As a result, multi-billion dollar losses due to trading risk are surprisingly frequent at large banks – even those well managed o The higher the inherent risk in the bank’s portfolio, the more capital the bank needs to hold to make sure it remains solvent Cyber risk and other operational risks:  Operational risk – risk of loss resulting from inadequate or failed internal processes, people and systems  Operational risk includes cyber risk – losses that arise when information technology systems fail or are compromised  Financial sector is both vulnerable and a target o Financial institutions, markets, and third-party vendors are reliant on information and communications technology o They have enormous client databases  Burden of protecting electronic records and networks falls on individual firms o Creates a problem because of potential for spill-overs when data breaches occur – if key personal identifiers can be used fraudulently, entire financial system may be at risk o Means there is a role for government (in cooperation with private sector) in promoting cyber security  Challenge will be to keep up with malicious actors o Firms and regulators need to anticipate prospective risks, rather than ensure compliance with rules that address past incidents Summary of sources and management of bank risk: Downloaded by Long ([email protected])  lOMoARcPSD|26117221 Lecture 8 – Financial industry structure Competition and consolidation:  U.S. banking system is composed of a large number of very small banks and a small number of very large banks  Primary reason for this structure is the McFadden Act of 1927 o This legislation requires that nationally chartered banks meet the branching restrictions of the states in which they’re located o Because some states had laws that forbade branch banking, result was numerous very small banks o Advocates of legal limits on branching argued they prevented concentration and monopoly in banking  McFadden Act produced a fragmented banking system nearly devoid of large institutions o Result was a network of small, geographically dispersed banks that faced virtually no competition o In many states, more efficient and modern banks were legally precluded from opening branches to compete with small, inefficient ones already there  Some banks reacted to branching restrictions by creating bank holding companies o Holding company – corporation that owns a group of other firms Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o Initially they were created not just to evade branching restrictions, but to provide non-bank financial services in more than one state  Technology eroded the value of local banking monopolies o In 1970s and 80s, states responded by loosening branching restrictions o In 1994, Congress passed Riegel-Neal Interstate Banking and Efficiency Act – reversed restrictions put in place by the McFadden Act o Since 1997, banks have been able to acquire an unlimited number of branches nationwide o Number of commercial banks has fallen by about a half o Number of savings institutions fallen by more than a half  Riegle-Neal Act allowed banks to diversify geographically o Banks became more profitable o Operating costs and loan losses fell o Interest rates paid to depositors rose while interest rates charged to borrowers fell  Financial crisis of 2007-9 focused attention on costs of deregulation o Has deregulation encouraged banks to take on too much risk? o Has deregulation motivated some banks to become too big to fail in order to secure a government bailout in the event of distress? Key legislation affecting the U.S. banking industry: The future of banks:  In November 1999, Gramm-Leach-Bliley Financial Services Modernisation Act effectively repealed the Glass-Steagall Act of 1933, allowing a commercial bank, investment bank, and insurance company to merge and form a financial holding company o Citigroup, which already included all three, became legal o Investment firms like J.P. Morgan were acquired by commercial banks o Commercial banks like Bank of America have purchased large securities dealers and retail brokers Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o To serve all customers’ financial needs, bank holding companies are converting to financial holding companies  Financial holding companies are a limited form of universal bank o Type of firm that engages in a wide range of financial (and possibly non-financial) activities  In the U.S., different financial activities must be undertaken in separate subsidiaries, and financial holding companies are still prohibited from making equity investments in non-financial companies  Owners and managers of large financial firms cite three reasons to create them (financial holding companies): o Range of activities, if properly managed, permits them to be well diversified o Firms are large enough to take advantage of economies of scale o Companies hope to benefit from economies of scope  Thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organisation  As we survey the financial industry, we see two trends running in opposite directions o Large firms are working hard to provide one-stop shopping for financial services o Pressures are growing on governments to restrain or even break up the largest, most complex intermediaries that might need government support in a crisis Non-depository institutions:  Five categories of non-depository institutions: o Insurance companies o Pension funds o Securities firms – including brokers, mutual-fund companies, and investment banks o Finance companies o Government-sponsored enterprises  Non-depository institutions also include an assortment of alternative intermediaries: o Payday loan centres o Rent-to-own centres o Peer-to-peer lending firms o Pawnshops o Loan sharks Insurance companies:  Insurance companies specialise in three of five functions performed by intermediaries: o They pool small premiums and make large investments with them Downloaded by Long ([email protected])  lOMoARcPSD|26117221 o They diversify risks across a large population o They screen and monitor policyholders to mitigate the problem of asymmetric information  Insurance companies offer two types of insurance – life insurance, and property and casualty insurance o Life insurers sell policies that protect the insured against the loss of earnings from disability, retirement or death o Property